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The role of emerging market bonds

Vassilis Papaioannou from Dolfin’s investment team explains why the emerging market bond asset class has a valuable role to play in a well-managed portfolio

30 May 2016 / Investing

Emerging market (EM) bonds should form part of a well-diversified portfolio from a multi-asset perspective. But it is important to accept that they are not a substitute for developed market bonds that you may hold in addition, for example, to equities. This is because an exposure to the EM bond world provides exposure to a range of factors as well those such as interest rate and credit risk, which standard fixed income holdings would provide.

Investors need to adopt a multi-dimensional approach in identifying all the risk factors.

An investor may gain a positive correlation with commodities, say oil, minerals or agricultural products perhaps, depending on the economic characteristics of the emerging markets in question. At the same time there is the higher growth rate potential which tends to be typical of emerging markets. And so apart from receiving a coupon, it is important for investors to adopt a multi dimensional approach in identifying all the risk factors that are embedded into EM bonds and to query how they feel about these exposures.

Gaining EM bond exposure

There are several routes to gaining EM bond exposure and they each have their respective merits.

You could approach EM bonds either directly via sovereign bonds, or corporate bonds issued by local names or via agency bonds. You could approach them by single lines issued by specific names or by exchange-traded funds (ETF) that tend to be more liquid.

If we view the EM market from an index perspective, for example the EMBI, the JP Morgan Emerging Markets Bonds Index, can be regarded, as a proxy for the EM bond world, then there is significant equity exposure as well as that to fixed income. These two factors account of 80% of the EM bonds return variation.

Geographically, by emerging markets we could be talking about BRICs at the top of the list but also broad regions such as Latin America, Southeast Asia, Africa, or Central and Eastern Europe. On the sector side, it could be industrials or financials – sectors that have a more cyclical component and are more extrovert. There could be exposure to, say, the domestic consumer environment but also to the wider world economy via import or export trade that issuers may engage in.

At Dolfin we keep a watch list of specific names using particular metrics to identify opportunities.

Strategy and tactics

Timing is an important consideration. In terms of single lines, the market has had a good rally over the last several months. The average yield to maturity is typically between 3% and 4% and most of the bonds are currently trading above par, so we would not offer any strong buy recommendations on the single lines. At the moment there are not many opportunities that would encourage investors to jump in to EM bonds to take a specific risk because the risk / return trade off is attractive.

ETFs are in some ways more attractive and convenient. They can be analysed much quicker and your position is much more diversified than holding a single line. You get the EM exposure that you want via a diversified instrument. Moreover you can use it tactically, trading in or out versus a long term buy and hold approach with single lines.

If you would like EM exposure, it is more prudent to do so via coupon bearing EM bonds.

Because the EM market is quite volatile, investors need to be quite careful on the duration side in order not to find themselves in the uncomfortable situation of experiencing drawdowns based on the volatile nature of the EM world. So we favour three to six years duration. In terms of risk, we think it is very important to have a three level approach: a macro assessment, the sector and then the specific asset view. If you are looking at a single name then you need to review the issuer. It is not as simple as say, buying US treasuries, where, the investor is not as concerned about the country specific macro picture as they would be in emerging markets.

Our view is that, if you would like EM exposure, it is more prudent to do so via coupon bearing EM bonds. At the same time you can use a tactical overlay in order to market-time some specific moves or, from a signal perspective, keep a check on your developed market bond holdings. Therefore, for a host of different reasons, we believe that EM bonds are a worthwhile consideration in managing a well-balanced portfolio.

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